Why a VAT Won't Solve Our Deficit Problems

There is always an easy solution to every human problem—neat, plausible, and wrong.—H. L. Mencken

The VAT (Value-Added Tax) has become the designated solution for massive federal budget deficits. It's touted by think tank economists and mentioned by congressional leaders. A VAT could raise stupendous amounts of money, which, Lord knows, are needed to cover projected deficits. A VAT is likened to a "national sales tax," so once it was in place, most Americans would barely notice it—just as they barely notice state and local sales taxes. How's that for friendly politics? A VAT would also discourage consumption and encourage saving and investment, making America richer in the future. What's not to like?

Mencken (1880–1956), one of America's great wits, would chuckle. Almost every pro-VAT argument is exaggerated, misleading, incomplete, or wrong. The VAT is being merchandised as an almost painless way to avoid deep spending cuts. The implicit, though often unstated, message is that a VAT could raise so much money that it could eliminate future deficits by itself. This reasoning, if embraced, would result in staggering tax burdens and exempt us from a debate that we desperately need.

How big a government do we want—and what can we afford? In closing deficits, what's the best mix between tax increases and spending cuts? What programs are not needed? How much should we tax the young and middle-aged to support the old? Should wealthier retirees receive skimpier benefits? Should eligibility ages for benefits be raised?

Our basic budget problem is simple. For decades the expansion of Social Security, Medicare, and Medicaid—programs mostly for the elderly—was financed mainly by shrinking defense spending. In 1970 defense accounted for 42 percent of the federal budget; Social Security, Medicare, and Medicaid were 20 percent. By 2008 the shares were reversed: defense, 21 percent; the big retirement programs, 43 percent. But defense stopped falling after 9/11, while aging baby boomers and uncontrolled health costs keep retirement spending rising.

Left alone, government would grow larger. From 1970 to 2009, federal spending averaged 20.7 percent of the economy (gross domestic product). By 2020 it could reach 25.2 percent of GDP and would still be expanding, reckons the Congressional Budget Office's estimate of the Obama budgets. In 2020 the deficit (assuming a healthy economy with 5 percent unemployment) would be 5.6 percent of GDP. To cover that, taxes would have to rise almost 30 percent. Gulp.

A VAT could not painlessly fill this void. Applied to all consumption spending—about 70 percent of GDP—the required VAT rate would equal about 8 percent. But the actual increase might be closer to 16 percent because there would be huge pressures to exempt groceries, rent and housing, health care, education, and charitable groups. Together, they're nearly half of the $10 trillion of consumer spending. There would also be other upward (and more technical) pressures on the VAT rate.

Does anyone believe that Americans wouldn't notice 16 percent price increases for cars, televisions, airfares, gasoline—and much more—even if phased in? As for a VAT's claimed benefits (simplicity, promotion of investment), these depend on a VAT replacing the present complex income tax that discriminates against investment. That's unlikely; the needed VAT rates would be implausibly steep. Chances are, we'd pay both.

Higher consumer prices from the VAT could also slow the economy. The Federal Reserve would face policy dilemmas. If it tried to prevent businesses from passing the tax along to consumers, it would have to raise interest rates and risk a recession. If it tried to blunt the effect of higher prices on spending, its easy-credit policy might trigger a new wage-price spiral.

A VAT is no panacea; deficit reduction can't be painless. We'll need both spending cuts and tax increases. A VAT might be the least bad tax, though my preference is for energy taxes. But what's wrong with the simplistic VAT advocacy is that it deemphasizes spending cuts. The consequences would be unnecessarily high taxes that would weaken the economy and discriminate against the young. It would become harder for families to raise children. VAT enthusiasts need to answer two questions: What government spending would you cut first? And how high would your VAT rates go?